Gundlach’s crisis-era bet holds rising-rate lesson

DoubleLine Capital founder focuses on yield per duration in fund

By

BenEisen

NEW YORK (MarketWatch) — Bond investor Jeffrey Gundlach is finding that an investment strategy born in the wreckage of the financial crisis is still holding up as interest rates begin to rise. And that strategy carries a broader lesson for investors fearful of rising rates, he said in an interview with MarketWatch.

Gundlach, who in 2008 was managing money for TCW Group, made a gamble on badly battered non-agency mortgage-backed securities, which were tainted by the real estate bust that followed a period of expansive U.S. home-buying. The securities, backed by mortgage loans not guaranteed by the government, were cheap, and for some, far too risky. But Gundlach focused on how they held up against other bonds, particularly bonds issued by companies.

Jeffrey Gundlach of DoubleLine Capital

“The first deep discounting in credit hit non-agency mortgage securities,” he said in a letter to investors at the end of 2008. “I believe this sector has offered a dominating risk-reward profile versus other investments.”

The money manager departed TCW to launch Los Angeles-based DoubleLine Capital in 2009. The company has $49 billion in assets under management. But Gundlach’s flagship Total Return Bond Fund
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, which beat out 82% of peers so far this year, is still built around the fundamental value of mortgage-backed securities. Over 30% of the portfolio is of the non-agency variety, and another 50% of the fund is made up of agency-sponsored MBS.

The Total Return Fund’s retail share class
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has an expense ratio of 0.73%, slightly above Morningstar’s median. The expense ratio for the institutional shares is 0.48%, just below average.

Miller Lite concept

Gundlach has been bullish on securities backed by mortgage loans since his early days of investing, when he looked at how they performed differently than corporate bonds.

“They all had about the same return when you look at three-to-five year periods, and yet mortgages always had the lowest volatility,” Gundlach said in an interview. He called it a “`Miller Lite’ kind of concept,” invoking the beer’s motto of “Great taste, less filling.”

When the crisis hit, Gundlach was mainly buying agency-guaranteed mortgage-securities, which are sponsored by government entities, and thus immune from most of the credit risk associated with mortgage defaults. But as investors switched out of badly-hit non-agency mortgage securities, he began snapping up the unwanted debt.

Fast forward half a decade and the bond market has making a transition from an era of falling rates to one where they’re expected to rise as the Federal Reserve normalizes its near-zero policy rate. After hitting a record low yield in 2012, the 10-year Treasury
US:10_YEAR
traded at 2.70% Monday. It’s still below pre-crisis highs of above 5% in 2007, but most expect the benchmark yield to continue rising in the coming years

Nonetheless, Gundlach is holding tight to his crisis-era bet. And embedded in that investing methodology is a way to manage bond investments in a market that’s afraid of rising rates, he says.

The lesson is one that’s touched on by other bond-fund managers, from Vanguard’s Ken Volpert to Pimco’s Bill Gross. Its roots lie in the popular Sharpe ratio, introduced by Nobel Laureate William Sharpe in 1966 as a means of computing risk-adjusted returns. But for Gundlach, it’s become a crucial part of his portfolio management DNA.

Duration, bond market’s dirty word

At a time where investors fear rate spikes, bond buyers are looking to get as much yield as they can while minimizing their exposure to interest-rate volatility. Duration, which measures volatility by showing how much value securities lose as rates rise, has become a dirty word in the bond market.

“Today with this universal fear of rising interest rates, most people would conclude that shorter duration would be your friend,” said Gundlach.

Gundlach speaks clearly and with the tranquility of someone who manages money in city where it’s always sunny. But it’s evident that his mind dwells in the murky world of bond math, churning investing ideas through complex models. When asked about some of the specific tenets of his credit analysis, he tosses out some of the broader concepts, but notes that the models he uses have been honed over years, and could take a week to explain.

Gundlach, like many bond managers, has reduced duration in DoubleLine’s Total Return Bond Fund. But that’s not the end of it. He goes hard-core on duration. He obsesses. His recipe for minimizing interest-rate risk is, after all, a main reason for owning non-agency mortgage-backed securities.

Start with the 12-month dividend yield of the DoubleLine Total Return Bond Fund, which is a proxy for the amount of income paid out to investors. Divide the dividend yield by the duration of the fund to get a ratio of how much income is generated for each amount of interest-rate risk taken on.

“What you’re really plotting is a forward-looking predictive starting point,” said Gundlach. “In an environment today where everyone is so concerned about rising interest rates, this becomes even more important.”

The goal is to generate a ratio that is as high as possible for the fund, which means that ideally the risk from rising rates is kept at bay.

The DoubleLine Total Return Bond Fund has a ratio of 1.25. That’s higher than any other intermediate-term bond funds that have been around for at least 3 years and have more than $500 million in assets under management. The 118 funds in the group had an average ratio of 0.54, according to analysis by MarketWatch using Morningstar data through the end of March. Other funds that produced a high ratio include Frost Total Return Bond Fund
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(ratio of 1.15) and Delaware Diversified Income Fund
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(ratio: 1.02)

It’s important to note that focusing on this ratio doesn’t protect against other forms of risk, such as currency risk and credit risk that could impede returns. As crisis-scarred investors remember well, non-agency mortgage backed securities dropped precipitously in value at the onset of the financial crisis for reasons wholly unrelated to interest rates.

But at a time when interest rate fear seems to be trumping all else in bond investors’ minds, this is a worthy way of honing in on the amount of exposure to interest rate volatility, Gundlach says.

Bracing for lift-off

For Gundlach, one type of security that best fits this mold is, you guessed it, non-agency mortgage-backed securities. Many have minimal duration while paying out relatively higher yields. He notes that their prices may be susceptible to other risks, such as fund flows and prepayment on mortgages, but that they reliably provide a higher ratio of yield to duration than most other securities. That’s what has helped the securities perform both as rates fell, and, now, as they begin to rise.

Morningstar analyst Sarah Bush wrote in an analysis last summer as the bond market was suffering from sharply rising yields that the Total Return Bond Fund’s performance had “moderated” recently compared with the outsized returns in its first few years of existence. But she added that Gundlach was still beating out most competitors, “thanks in part to strength in its nonagency holdings. The fund hasn’t totally escaped losses in the recent bond market sell-off, but its relatively short duration has helped protect it.”

Using yield-to-duration, Gundlach also finds value in some bank loans and emerging-markets dollar denominated bonds, which are holdings in his DoubleLine Core Fixed-Income Fund
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(yield to duration ratio: 0.93).

For bond investors trying to generate income in an era of rising rates, there’s no substitute for careful selection of securities. But at a time when everyone is bracing for the risk of rising rates, knowing how much you are earning for that risk is a framework for making the tough investment decisions, says Gundlach.

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